Over the years, I have seen many financial institutions struggle with the adverse action notice requirements under Regulation B, especially in regards to what denial reasons should be listed on the adverse action notice. This is particularly true when an applicant is denied for a reason relating to income and the applicant’s debt-to-income (DTI) ratio as most adverse action notice vendors provide two similar, but different, options relating to income: excessive obligations in relation to income and insufficient income for the amount of credit requested.
In this article, I will attempt to explain my understanding of the difference between these two income denial reasons and provide clarification on how a bank can know when to use one reason and not the other - or both.
Providing a Statement of Specific Reasons Under Regulation B
The challenge in understanding the difference between insufficient income vs excessive obligations is that the rules don't clearly tell us which reason to use - all they say is that you must provide a specific reason.
(2) Statement of specific reasons. The statement of reasons for adverse action required by paragraph (a)(2)(i) of this section must be specific and indicate the principal reason(s) for the adverse action. Statements that the adverse action was based on the creditor's internal standards or policies or that the applicant, joint applicant, or similar party failed to achieve a qualifying score on the creditor's credit scoring system are insufficient.
As Regulation B does not provide guidance as to what specific denial reasons should be used under what specific circumstances, financial institutions are often left scratching their heads trying to determine which reason is appropriate for their denials.
Background on Excessive Obligations vs Insufficient Income
As far as I have been able to tell, the two reasons of excessive obligations and insufficient income come from the sample adverse action notification form (model form C-1) found in Appendix C to Regulation B. This model form is optional to use, but it clearly has had influence on many adverse action forms vendors due to their adoption of the reasons for denial found on the model form. As model form C-1 provides two DTI reasons for denial, many have believed that these reason are, in fact, separate and distinct and the general consensus on when to use these reasons seems to go back to a resource utilized by many financial institutions called the Adverse Reason Chart (found here). This chart defines insufficient income and excessive obligations as follows:
“Income Insufficient for Amount of Credit Requested. Should only be used where borrower’s current debt-to-income ratio is within bank standards, but when requested credit is added in (and any debts to be paid off are subtracted), the ratio exceeds the standards.”
“Excessive Obligations in Relation to Income. Should be used where borrower’s existing debt-to-income exceeds the bank standards even before adding in the requested credit.”
Over the years, these definitions of insufficient income and excessive obligations are what I typically use, though each financial institution is free to define them any way they wish, though fair lending implications would make it prudent to be consistent in the use of each denial reason.
Using Excessive Obligations vs Insufficient Income
Over the years as a consultant and speaker, I have taken the best practice approach that each denial reason on the AA Notice should be clearly traceable to the loan file. Therefore, I've typically recommended internal procedures (such as the chart I referenced previously) to provide guidance as to when each DTI reason should be used.
For example, if an AA Notice lists insufficient income (and assuming the bank defines it the way I referenced above), then I would expect the DTI in file to include the proposed payment and to also be higher than the financial institution’s policy maximum DTI. Alternatively, I would expect that a reason of excessive obligations would include a DTI in the file that is too high but does not include the proposed payments in the DTI calculation. If both reasons were listed, I would want to see evidence in the file that the DTI was both 1) too high before the proposed payment as well as 2) being too high after the proposed payment was added in - meaning that it would be ideal to have two DTIs in the file.
From my experience, every financial institution calculates the DTI ratio in a slightly different way as I have seen some utilize an underwriting template that calculates the DTI both before and after the proposed payment is added in. Other financial institutions just run the DTI with the proposed payments while others may not even include the proposed payment if the initial DTI is too high (though I have seen where this is problematic during a fair lending review when the proposed payment would have actually reduced the DTI where it could have been approved under bank standards).
Applying Consistency in Excessive Obligations vs Insufficient Income
For me, the bottom line is to make sure that a financial institution’s underwriting process aligns with how they list their adverse action reasons. How can you do this? First, you would need to determine how you calculate your DTI (whether you calculate it before the proposed payment is added, after it is added, or both). Next, you would determine how this will apply to listing your AA reasons. For example, if you calculate both the before and after DTI, you would want to list both reasons when applicable. Finally, you will need to ensure that all employees providing adverse action notices are using the denial reasons of excessive obligations and insufficient income in a consistent (and appropriate) manner.
All of this said, the rules don't define the difference between excessive obligations and insufficient income, so a different approach to this could be acceptable. For training and logistical purposes, however, I have just found it best to drill down procedures so that each denial reason can clearly be traced to the application file as this will ensure consistency for both for staff as well as auditors/examiners.